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As deficit soars, bond investors embrace 'Sugar Daddy' fiscal policy

·Editor focused on markets and the economy

The bond vigilantes of yesteryear who used to enforce fiscal discipline by spurring higher interest rates may have been bought off by a free spending “sugar daddy” named Uncle Sam.

The disappearance of that particular class of investor —who seem to have all but disappeared in an era of trillion dollar spending deficits and a softening economy — is one of the enduring mysteries of global markets.

Although the U.S. yield curve may or may not be signaling the onset of a recession, rates remain near historical lows, even amid an endless sea of government red ink.

These days, bond markets largely take their cues from the Federal Reserve’s one-two monetary punch of bond buying and interest rates. Yet veteran market watcher James Paulsen believes investors “worry too much about the Fed,” and should recognize that markets have “switched to a new juice.”

That particular beverage happens to be a federal government intent on cutting taxes, while spending with seemingly reckless abandon.

“Should stock and bond investors be leery of the unconventional contemporary fiscal environment, or should they simply relax, admit the Fed may have lost a step and just embrace their new Sugar-Daddy’s fiscal juice?” Paulsen asked in a research note to clients on Monday.

The link to MMT

Elements of Paulsen’s argument dovetail with Modern Monetary Theory (MMT), a hotly debated economic theory that posits a government can stimulate the economy via infinite deficit spending. In theory, a government that can print money can’t ever run out of it.

The idea of Uncle Sam as a “Sugar Daddy” has adherents on both sides of the political spectrum, but is generally viewed as a precursor to surging inflation, unsustainable deficits and a currency that ends up worthless.

Yet a few market observers say that current economic conditions, primarily a strong jobs market and resilient consumer demand, could counteract the effects of deficit spending on yields.

The U.S. Treasury Department building in Washington. (AP Photo/Pablo Martinez Monsivais, File)
The U.S. Treasury Department building in Washington. (AP Photo/Pablo Martinez Monsivais, File)

Philipp Carlsson-Szlezak, an economist at Bernstein Research, noted this week that “it's not clear – from an orthodox economic perspective – how expanding deficits in the context of full employment coexist with falling interest rates, as MMT suggests would be the case.”

Still, he insisted that a full embrace of MMT “would end badly, as in a currency/ inflationary collapse.”

The current debate over MMT is being deployed “politically to give expansionary fiscal policy a new intellectual veneer,” Carlsson-Szlezak wrote, adding that the “compulsive stimulus” of the last few decades have given MMT fresh legs.

Still, “as with all such fiscal stimulus, including President Trump's unabashedly pro-cyclical tax cuts” — deficit-fueled growth results in tradeoffs and a number of economic risks, he added.

Investors still snapping up bonds

Yet all things considered, bond yields have yet to register disapproval of a profligate government. Whipsaw markets and a slowing global economy have driven investors to the relative safety of government debt, which drives up prices and depresses yields.

Indeed, Deutsche Bank noted this week that fund flows continue to rotate towards bonds and out of equities, to the tune of $11.4 billion in the latest week, and over $150 billion year to date.

“The persistent outflows despite the strong equity rally are unusual but...have been driven by investors chasing falling yields,” Deutsche said in a research note on Monday.

All of which begs the question about why Wall Street seems unfazed by surging deficit spending. A January Congressional Budget Office analysis showed the federal debt will be as big as 93% of U.S. GDP within the next decade, with the federal government expected to run trillion-dollar deficits every year beginning in 2022, if not sooner.

Even with that in mind, bond yields are only expected to rise modestly over the next year.

According to Bank of America-Merrill Lynch, the 2-year note is expected to hit 2.60% by the end of 2019, up from 2.34% currently. Meanwhile, the 10-year is expected to rise to 3% (up about ½ a basis point from current levels) in the medium-term, and 30 year bond to yield 3.30% (up barely ¼ a percent), the bank says.

Embracing ‘sugar daddy’

For his part, Paulsen argued that “while large public deficits may have long-term negative implications, in the intermediate term, fiscal juice has generally been friendly to investors. According to his analysis, U.S. government bonds have actually performed strongly during times of fiscal red ink.

“The largest public deficits typically occur during recessions, when ample economic slack allows bonds to do well, and substantial fiscal accommodation improves the earnings-growth outlook for stocks,” Paulsen added.

While investors are betting the soft economy will prompt the Fed into action —which may include an interest rate cut if things get bad enough —Paulsen said markets should worry less about Fed Chair Jerome Powell, and more about President Donald Trump’s tax and spend agenda.

“Currently, in unconventional fashion for an economic expansion this old, Powell’s sugar has been replaced by Trump’s Juice,” Paulsen added. “Consequently, in the coming year, investors may want to embrace their New Sugar Daddy!”

Javier David is an editor for Yahoo Finance. Read more:

Follow Javier on Twitter: @TeflonGeek